Reckoning with recession risk: Why this one may be “pricey”

Jitu Naidu, Investment Communications Manager
2022-11-30
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

As of this writing, one of the most heated debates taking place within the investment community centers around the looming risk of a global economic recession. Are we likely to enter one? If so, when? How long and severe might it be?

Our take: The global economy is on the cusp of what we’re calling a “pricey” recession scenario, which could be very different from past recessionary periods. We may see a slowing in real (inflation-adjusted) economic activity, in  line  with  the  lagged  impact  of  tighter global financial  conditions. However, the nominal pulse  of most  economic indicators  could  remain  elevated  as inflation stays “sticky” at today’s high levels.

Key drivers of sticky inflation

At the heart of our “pricey” global recession scenario lies the thorny issue of persistently high structural inflation, fueled in large part by:

  • Deglobalization. The ongoing Russia/Ukraine conflict, China’s growth fragility, and the unique nature of  the post-pandemic  recovery have all accelerated the trend toward  greater localization  of production and labor markets. Hence, global supply capacity will likely become notably less flexible in the future and slower to adjust to changes in demand. The implication is not only that global inflation rates may be higher, but also that inflationary pressures may become more responsive to fluctuations in demand than they have been for several decades.
  • Supply shocks. The bigger theme is the near-term global policy response to a series of supply shocks that have contributed  to deglobalization. Most  countries have responded to  these  supply  shocks through various transfers and subsidies. Fiscal policymakers have multiple objectives, most of which run counter to the simple monetary policy goal of stable inflation – for example, transitioning to more sustainable energy, curtailing China’s geopolitical influence, and narrowing income inequalities. Such priorities often work against the organic demand destruction required to lower and stabilize inflation and may be even more difficult to achieve if the global economy falls into recession.

In short, the cumulative impacts of deglobalizing supply chains and labor markets, driven by geopolitical realignment and compounded by decarbonization (spurring demand for commodities used in the adoption of renewable energy sources), are feeding into higher structural inflation.

The recession risk question

The pressing question is whether the current global economic slowdown is temporary or a sign of a deeper global recession. On balance, we think it probably marks an economic “pause” rather than the onset of a protracted recession. If we are right, the global cycle should begin to bottom later this year, followed by a  gradual  upturn  in  economic  activity. Decelerating global  growth  and  easing  supply  bottlenecks  will temporarily lower monetary policy tightening expectations. However, strong developed economy labor markets  and activist  fiscal policies to  support global demand  could  keep  structural  inflation stubbornly higher.

  • The US: Growth  is  slowing on  the  back of less accommodative US Federal  Reserve  (Fed)  monetary policy and correspondingly  tighter financial  conditions. However, upside  risks  remain  from  excess household savings, sharply rising credit growth, state and local fiscal easing measures, and the recent passage of federal spending packages. Something to watch for amid this particular cycle will be the US corporate  attitude toward labor. Until the labor market cools, and/or inflation moves decisively lower, the Fed will likely stay vigilant to guard against the risk of an upward wage-price spiral.
  • Europe  and  Japan: As global recession fears rise in  the  period  ahead,  we  think  there  will likely be policy responses designed to combat the threat to national economies, which in many countries will take  the  form  of  even more  aggressive fiscal stimuli,  especially  in  Europe  and  Japan. That,  in  turn, could amplify inflationary concerns in both regions.
  • China: China’s economic cycle  is  likely  to  be  erratic going  forward, characterized  by a ”start-stop” dynamic rooted  in continued  underlying  problems  in  the  property  sector and  (given developed markets’ shifting demand patterns)  exacerbated by weakness  in  the  trade-intensive  manufacturing sector, along with the country’s still-stringent COVID policy.

Final thoughts

It’s important to note that when global inflation is as elevated as it is these days, there are no guarantees that central  banks can orchestrate “soft  landings” for  their  respective economies. However, it’s not impossible.

For example, in the US, barring a meaningful and sustained improvement in labor supply or productivity (not our baseline), the Fed may have to reduce aggregate demand via rate hikes in a more material way to bring inflation  back  toward its 2% target. A Fed that successfully  anchors inflation  expectations, in conjunction with well-targeted US fiscal policy, might be able to put the nation’s economy on a path where the inflation rate can normalize without inflicting serious economic damage.

Coming soon

In our follow-up companion blog post, scheduled to publish next week, we will share our thoughts on how investors might position for the potential recession scenario we’ve described here.

Expert

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